Tariffs = Beautiful word (Part 1)

The world is abuzzzzzzzz with tariffs :)

Markets have see-sawed, a host of international leaders have made a stream of appearances at the White House and in general there has been a lot of questions in the trading community (to put it mildly).

We have often heard the phrase that "Tariffs is a beautiful word". Let's delve into this beautiful world and discover the world unknown to most of us.

It has taken many many decades to get to the state of world economy that we have today. There are two key moments from the past ten lustrums. The first one is United States deciding in 1971 to no longer peg the value of the dollar to gold. This had lasted from 1945 to 1971 and was known as Bretton Woods era. During this time the value of dollar was pegged to gold and the value of other currencies was pegged to the dollar. In 1971, United States decided to no longer peg the dollar to the value of gold. The reasons behind this is like opening a Pandora's box and we will save that for another rainy day :)

The second one is China being accepted into the World Trade Organization. This happened on December 11th, 2001. This led to China being able to access markets around the world. As such, China was open for firms to invest in the country and get access to the local market. China used its might in manufacturing and low cost labor and specialized skills to become the world's manufacturing hub. As such China exported a lot more to the world than it imported. Now, this is a sliver of the trade imbalance that exists between the developed countries around the world and the developing countries.

What does all this have to do with tariffs? 

Tariff by definition is a tax. It is a tax that must be paid before a good is brought into the country. This tax is paid by the importer. Many countries have adopted tariffs when it comes to protecting their own economies. South Korea imposed tariffs on import of cars into the country. These tariffs were imposed in 80s. Today's Kia and Hyundai and their global presence is mainly due to the then government imposing tariffs on imports. This led to local companies investing in the technology, skills and equipment to design, build and deliver cars to cater to the demand of the population. As their skills and expertise grew, these companies became better and better on building cars and today Kia and Hyundai are global powerhouses when it comes to car manufacturing. 

India is another country that has used tariffs to protect its own economy. India is well aware that they have a population that a lot of companies would love to have access to and sell their products. Take automobile/motorcycles for example. India has a tariff of 110 percent of any motor vehicle imported into the country. This has led to many global companies setting up factories in country and producing vehicles that cater to needs of local population and in some instances exporting too. While India has been unable to develop global powerhouses such as Kia and Hyundai, they nevertheless have homegrown companies such as Mahindra and Tata motors that are well respected within the country. 

We get an idea of what tariffs are used for. Isn't it a beautiful word? 😚

So what does the end of Bretton Woods area have to do with tariffs and the trade imbalance we see today? It gave rise to the floating exchange rate system.The exchange rate is determined by the supply and demand for the currency in the foreign exchange market. We are all well aware of the demand for United States dollar in the foreign exchange market. This has led to a huge disparity in terms of the exchange rate for local currencies in developing market against the dollar. 

Now there is a caveat. Some countries do not let their currency value determined by the floating exchange rate system. They fix it. China is a well known example of fixing the value of yuan against the dollar. They do this primarily to benefit their exports. Bangladesh is another country that has fixed the value of their currency against the dollar to benefit their exports. Currently Bangladesh exports almost $9 billion worth of goods to the United States and they import approx $2.9 billion worth of goods from the United States. This leads to a trade imbalance of approximately $6.1 billion. 

Now you see where we are going with this? If only all countries had pegged the value of their currency against the dollar.... smh!

So how do we fix the trade imbalance? We will save that for part 2.

I'll give you a hint though - John Maynard Keynes. 

Honey... show me the money!

Let's talk money.  

We all need money to carry out day to day transactions in our lives. Whether it is to visit the grocery store or buying food on an airplane or whatever in between. 

So let me ask a question. How much money do you have? 

The first thing that comes to mind is "Okay.. maybe this person is asking. How much cash do I have?". On an average folks might carry anywhere between $20 to $100 in cash for day to day use. Of course we all love to use the plastic card everywhere we go, cuz it is convenient. But imagine for an instant that we carry cash everywhere we go and for each and every transaction. Wouldn't that be a pain? 

Now let's ask, how much money is in circulation? Let's use a systems approach and break it down. Money includes Currency, traveler's checks, demand deposits and yada, yada, yada....

Humor me for a minute. Let's say you live in California with a population of ~50 million people. And let's say on an average a person carries $40 in currency. So, one can appr oximate it to be ~2B in currency  Now we of course assume that every infant, toddler and teenager is carrying $40 in cash. I know it is preposterous. Chill, it is just an assumption.

On the other hand, let's ask this question. How much currency is in circulation in the United States? In order to answer this question, let's turn to our favorite friend "The Federal Reserve". The amount of currency which includes notes and coins in circulation as well as the reserve balances at the Federal Reserve is referred to as "Monetary Base" or denoted by M0.

Reserve balances are deposits held by banks and other institutions in their accounts at the Federal Reserve. So just like you have a bank account with the Bank of America, so does the Bank of America have a bank account with the Federal Reserve.

This is an interesting attribute. Did you know that in 2003 the value of M0 was ~630 Billion, but in 2020 that value has ballooned to ~4.7 Trillion. So what the heck happened? 

 

 You can credit most of this money creation to our good old friend, Ben Bernanke. Pay attention to the above chart. In September 2008, the value of M0 was ~$900 Billion and by December 2008 that ballooned up to $1.7 Trillion. This is what is meant by the Fed creating money from thin air. More on this in a subsequent post. Anywho.. the value of M0 which includes currency as well as reserve balances is now standing close to $4.7 Trillion. 

Now let me introduce to the next attribute M1, which is defined as the currency held by the public and the transaction deposits at the depository institutions (aka "Banks"). The value of M1 in February 2020 was $4 Trillion and as recently as August 2020 is $5.4 Trillion. Notice the huge spike in the graph below from March and on as the pandemic took shape. People started saving more and resulted in a spike in currency and deposits held by the public.

 

 The next attribute is M2, which includes M1 as well as savings deposts held at banks, time deposits for amounts lesser than $100,000 and money market securities and mutual funds. The latest value of M2 as of August 2020 is $18.3 Trillion. Again this rose from just $15.3 Trillion in February 2020 to a whopping $18.3 Trillion by August. We should say a big thank you to Jerome Powell (If you know what I mean 😉). 

The following image shows a systems approach to understanding Money Supply. 

Unemployment Rate

These days the most commonly used word amongst folks setting the fiscal policy and monetary policy is the unemployment rate. It has been quoted numerous times in the news channels and no wonder this indicator has taken a turn for the worse recently. So what exactly is unemployment rate? Bluntly speaking, it provides a snapshot in time of the number of persons out of the total working age population who are eligible to work, but cannot find work. 

You still with me? Let's break this down. 

The total population of the United States is 330 Million. See the graph below from FRED.

     

Now this can be further broken down as 

 

1) Civilian Non-institutional population (~260 Million) 

2) Civilian Institutional Population (~70 Million)

Civilian Institutional Population includes persons living in military installations, correctional and penal institutions, dormitories of schools and universities, religious institutions, hospitals and so forth. In order to calculate the unemployment rate, we consider only the Civilian Non-institutional population (~260 Million). Let's break this down further in to three distinct categories 

    1A) Young Population i.e. persons who are below 15 years old:                             ~49 Million 

    1B) Working age population i.e. persons who are between 15 and 64 years old:    ~170 Million 

    1C) Elderly population i.e. persons who are above 64 years old:                             ~41 Million 

The labor force participation rate is about 61 percent of the total Civilian Non-institutional population i.e. 61 percent of 260 Million which is ~159 Million. This indicates that while the working age population is 170 Million, the labor force participation rate is ~159 Million. So what happened to the remaining 11 Million?  These persons could have decided for various reasons to not actively look for work. They might have decided to drop off the labor force either because they have fallen off their ways, won a lottery or just decided that working is not for them. 

Out of the 159 Million persons, as of June 2020 the number of persons actively employed are ~142 Million, which leads to an unemployment rate of 11.1 percent. The graph below shows the unemployment rate since 2008 onwards.

   

For those of you who are numerically inclined, the following table gives the values for the past 6 months.

As you can see from above, the unemployment rate saw a shocking rise to ~15% in April and since then fallen to around 11 percent. Keep in mind, during the last recession in 2008-09 the unemployment was as high as 11 percent. Now do we see a V shaped recovery? Given the recent raise in COVID cases across the country and states rolling back some of the opening measures a "V" shaped recovery looks highly unlikely. 

So what happened in July 2020? At the time of writing this blog, July data has not yet been released. it is expected to be released on August 7th at 8:30am ET.

Consumer Price Index

Let's assume you like Trader Joe's, just like me and shop there regularly. 

On one fine mid-summer morning, you go to Trader Joe's and gently walk across the aisles. You indulge in soul soothing shopping, buying a few vegetables, meat, bread, milk and wine (of course!). Now you are happy-go-merry customer and the cashier processes your items for payment and lets say your average price per item is $3.50. 

Imagine you've done this once per week, all summer. Now, come fall you continue your routine and visit Trader Joe's once a week, just like you did all summer. And let's assume you are purchasing the regular items  such as vegetables, meat, bread, milk and wine. Now, when your order is processed by the cashier, you realize the average price has changed to $3.75! And you think.... what the heck??

Consumer Price index measures the change in price level of an average basket of goods purchased by households. In this case the average price of the items purchased in Trader Joe's changed by a whopping 7.15 percent. 

Practically speaking, if we ever encounter a CPI of 7.15 percent, we are having runaway hyper inflation. Think Zimbabwe and it's 100 Trillion Zimbabwe Dollar currency note !

For the past 10 years in the United States, the Consumer price index has been relatively low (a modest 0.3-0.5 percent annually). This has been a worrisome trend for the Federal Reserve who was struggling to keep interest rates low when inflation was stubbornly low as well. Ahhhh.... those were the days pre COVID-19! :)

The Bureau of labor Statistics surveys the prices of 80,000 consumer items to create the index. It represents the prices of a cross-section of goods and services commonly bought by primarily urban households. They represent 87 % of the U.S. population.

The Bureau of Labor Statistics publishes the Consumer Price Index for every month. It is released two weeks after the end of the month and can be viewed here

GDP ?!?!?!

So we're all screwed!

I vividly remember when I started my career in early naughts. Every corporation, everywhere had a "Vision 2020" goals and objectives. Some companies wanted to increase their revenue by X times, some wanted to expand in different markets, introduce new product categories and so on. Most corporations were using these buzzwords to drive their share prices up. 

Come 2020 and we're screwed. 

Many of us would prefer we fast forward to 2021, thanks to COVID-19 and the tragedy that has befallen many families and the world economy in general.

Depending on which entity you're following between International Monetary Fund, Federal Reserve, European Central Bank or the People's Bank of China, it is widely understood that GDP of different nations and the world is fucked. The estimates are average GDP contraction between negative 5 percent and 8 percent, depending on which entity you keenly follow. Let's take a look at is GDP and it's impact on the economy.

GDP stands for Gross Domestic Product. Simply put, it is the sum of all goods and services produced in a country in a given period of time. Did you know United States has a share of ~25 percent of the world GDP. You can find the GDP of different countries listed over here . GDP is an indicator of the economic health of a country during a given period of time. It is one of the most closely watched economic indicators. From a macroeconomic perspective, it plays an influential role in key business decisions companies make for the foreseeable future. Foreign Direct Investment in emerging economies depends on the GDP growth of the economy measured in percentage. World travel is intricately connected to GDP. Many airlines predict traffic growth in key markets and make investment decisions such as purchasing of aircraft based on GDP projections of countries they fly into. Governments customize their foreign policies depending on the GDP of the country their are interacting with. Bigger the share of the world GDP, bigger the influence. No wonder then, China and United States are the top two economies of the world. 

Now, for the economic geeks, lets take a look at the GDP formula. It is denoted by the letter "Y" and can be written as Y = C + G + I + Nx, where

C = Consumption

G = Government expenditures

I = Investment

Nx = Net Exports (Exports  - Imports)

Consumption is referred to the consumption by individuals in a country. Generally speaking, the more you consume the better it is for the economy and is indicative of disposable income.

Government expenditures is indicated by the monetary and fiscal policies in place by the government. When a government spends more, it generates more wealth usually amongst the population.

Investment refers to domestic private investment and is an indication of the confidence of businesses and lending companies in the state of the economy.

Net exports refers to total exports minus total imports. Ideally, it is preferred to have total exports marginally higher than total imports, thereby producing more in the country than what is imported for the country.

COVID-19 has turned all these parameters upside down. At the time this article is being typed, we don't know what is in store for the future. Airlines have virtually ground to a halt. Flying passengers traffic is down 95 percent year over year. Projections for when we go to pre-COVID levels is pretty dire. Financial markets have seized up and business to business lending has slowed down. Our friendly banker down the road, Federal Reserve has once again started to print money out of thin air and prop up the economy. As much as I am amused by the Fed's actions, without doubt the Fed Reserve deserves applauds for the swift way in which it has reacted to irrational markets and all the measures it has taken to calm the markets. Oil is of course at the mercy of MBS and Putin. Other than that, Jerome Powell deserves credit for his calm handling of this crisis. Nevertheless, there are about 30 million people who are on employment at this time. Given that Labor Force Participation Rate is ~$150M, it is a shockingly 20 percent unemployment rate. Certain states in the US are reopening in spite of continued tragic deaths due to COVID-19. Will this restart the economy and if so will it be a V-shaped recovery? It is doubtful.  How long before people feel comfortable going out and eating in restaurants? How long before people feel comfortable flying? Flying pre-COVID was a PITA. How is it going to look post-COVID? Are companies going to still invest for the long term? What if there is a second wave of coronavirus deaths across different parts of the world? These questions and a lot more weigh heavily on the minds of different people across parts of the world. 

If people are out of work and everyone is hunkered down and not really spending, except for essential items, it has a detrimental impact on GDP. If governments at different levels are declaring bankruptcies, what does it do to their expenditures? Are companies going to really invest at this time? The only imports and exports in these uncertain times seem to be PPE and ventilators. The impact to different countries' GDP is going to be severe and brutal. Many countries from Italy to India have been lockdown for an extended period of time.. You can't lockdown a few billion people and expect the economy to have a V-shaped recovery. The only hope we can have in 2020 is to find a vaccine that yields positive results, protect the vulnerable and slowly and steadily head back to the roaring world economy we had at the end of 2019.

Till then, 2020 is a year to forget. So much for "Vision 2020" .... huh! 

Inflation for dummies!

Inflation.... this the most sought after word in the Federal Reserve today. Janet Yellen and her governors are craving for inflation ever since they publicly annonced their intentions to raise the interest rates following the FOMC meeting in August, 2015. However, inflation today has been stubbornly low, in spite of money pumped into the economy. Let's take a look into what is inflation and what are the pitfalls.

Inflation by definition is a persistent and substantial rise in prices related to an increase in the volume of money. This also results in the loss of value of currency. When this happens, it's when stuff costs more. Whether it is a shiny new car or that new iPhone that you sooooo desire.

Typically, inflation is often misunderstood and villified. Let's start with how it is measured in the first place. The government has a shopping list of 80,000 items and services (for true!!).It collects the data on the prices of these items every month. It then averages and weights these prices using various formulas. The result is a number called Consumer Price Index (CPI). It is also sometimes referred to as Retail Price Index (RPI). The CPI is a measurement of how much stuff costs us. Currently, it is at 246. You can learn more by clicking here.

SO the general feeling is inflation is bad, because we don't want to pay more for stuff. Fair point. However, it depends on our situation. Let's look at a couple of scenarios.

Scenario 1:
Let's say you have $100 under a mattress. After one year, with a inflation rate of 3%, it will be worth $97. So, essentially your purchasing power has gone down.

Scenario 2: 
Let's say you invest that $100 in an investment with a 4 percent return. So in year from now you will have $100 + $4 = $104. However, since inflation has gone up by 3 percent, it will be worth $104 - $3 = $101. The real rate of return is only 1 percent

Scenario 3: 
Let's say you take a loan from a bank for $100 at a fixed interest rate of 2%. Hence, after one year you owe the bank $100 + $2 = $102. However, it will only be worth $99 due to three percent inflation. Hence, inflation has paid $1 of your debt.

Hence, if you owe money to an entity, inflation can be used to one's advantage. However, too much inflation is also not good. In the event of increased inflation, uncertainty about what will happen makes corporations and consumers less likely to spend. This hurts economic output in the long run. Lenders are less likely to make loans if they cannot accurately adjust rates to make up for inflation. Those with pensions or fixed income see a decline in their purchasing power and, consequently, their standard of living. If the inflation rate is greater than that of other countries, domestic products become less competitive.

In the event inflation gets really bad, people hoard tangible items as a way to shed excess cash before it is devalued. This creates shortages of the hoarded items. Hyperinflation can occur when a currency loses its value so rapidly that the very concept of currency becomes meaningless, such as the issuing of 'trillion dollar bills'. This often results in a complete breakdown of the economy.

So, does it mean we need to avoid inflation by all costs and measures?  Not necessarily. A modest amount of inflation is a sign of growing economy. To avoid inflation investors often convert assets from money to capital projects, creating more growth.

In the next post, we will learn more about the types of inflation and the tools available to combat inflation.

What is a mutual fund?

Buying a mutual fund is a lot like going in on a group gift or joining a co-op--with people you'll never meet. Mutual funds allow a group of investors to combine their cash and invest it. By pooling their money together, mutual fund investors can sample a broader range of stocks or bonds than they could if they were trying to buy the stocks and bonds on their own.

Many people think of mutual funds as "products." But when you buy a mutual fund, you're actually buying an ownership stake in a corporation that in turn hires a money manager to invest its money. The price of a single ownership stake in a fund is called its net asset value, or NAV. Invest $1,000 in a fund with an NAV of $118.74, for example, and you will get 8.42 shares. ($1,000 / $118.74 = 8.42.)

The underlying logic of mutual funds is that they provide diverse investments — in stocks, bonds and cash — without requiring investors to make separate purchases and trades. An individual would need more than $100,000 to build a similarly diversified portfolio of individual shares and bonds, but a mutual fund investor can send $1,000 to a fund company and find herself holding an ownership stake in a number of companies.

Mutual funds offer some notable benefits to investors.

1. They don't demand large up-front investments.

2. They're easy to buy and sell.

3. They're regulated.

4. They're professionally managed.

Mutual funds have costs, not just in terms of investment risk, but also in terms of fees. Like any investment, these funds have operating costs. Fees are disclosed in a fund’s prospectus under the heading “Shareholder fees”. The SEC does not limit the fees that a mutual fund can charge, but although the SEC limits redemption fees to 2%.